Kobe Steel: “We are extremely sorry for our improper conduct”

“We are extremely sorry for our improper conduct,” says the message on the front page of Kobe Steel’s Website. The scandal that has engulfed the company over falsifying product quality data is clearly uppermost on its mind. The company is facing an investigation by the U.S. Department of Justice, an external investigation prompted by the Japanese government, random lawsuits from Canadian customers owning cars with Kobe steel in them, and now a proposed class-action lawsuit that will be filed in the United States and possibly Japan, by law firm U.S. Market Advisors Law Group.

The biggest question, however, is how a company that already nominally had a culture of compliance with applicable rules and regulations, quality control systems, compliance committees, compliance directors, whistleblowing programs, and internal reporting systems got into this mess. If you have a company that says it already has these processes in place, and then admits that it has not complied with any of them, how do you convince customers and investors going forward that it is now going to comply? If the company already had all of these compliance practices in place, and the images from its annual report below clearly show that it did, what can it do to convince investors that things will actually change?

The Kobe Apology

We are extremely sorry for our improper conductAt this time, we sincerely and deeply apologize for the enormous amount of worry and trouble we have caused many of you in respect to the improper conduct concerning a portion of our products made by our company and group companies.The Kobe Steel Group, together with its suppliers, is quickly working to determine how its products have affected safety and other factors. We are thoroughly analyzing the cause and are engaged in developing countermeasures to prevent a reoccurrence from happening. We are making sincere efforts to eliminate the burden on all parties concerned and to resolve these problems as quickly as possible.

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David Abel, an attorney with U.S. Market Advisors Law Group (U.S. MALG), suggested that: “In most situations you have to have a change of personnel, because if you look at their compliance initiatives, they all make sense. If everybody were doing this we would catch things and employees would be able to report up the chain without retribution. If they are not doing it, you have to replace managers. I haven’t heard calls for the CEO to resign, he’s relatively new, we don’t know how much he inherited but it’s probably a lot. Was he really going to change things? Or was he complicit? At this point it seems likely that he knew what was going on before it was made public. At the plant level,” he added, “it seems like plant managers would need to be replaced because new training is not going to accomplish what you want. That would be most effective in assuring investors that they’re doing something.”

So what has happened? Kobe has said some 500 companies worldwide are in a supply chain that received falsified certifications on the strength and durability of metals and many other Kobe products going back to 2007. These 500 include Ford, GM, Boeing, Mitsubishi, Toyota, Nissan, Airbus, Honda, and Mazda, as well as companies operating nuclear power stations. Reports indicate that the company could face losses of as much as ¥200 billion (U.S.$1.8 billion), according to Nomura Securities Co. This includes costs associated with customers being forced to recall products and then have Kobe assume the cost and pay compensation, including to investors. Abel said: “From what we know today, it is extremely expensive, when product does not meet standards, to essentially redo things. Given their companywide push to reduce costs and error rates, the pressure was so much that instead of admitting that things were not complying with standards, they essentially fabricated the data so they wouldn’t experience the cost of having to bring products up to the standards required.”

Kobe Steel's Compliance Systems

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This is not the first instance of Kobe being engulfed in a scandal, however, but, apart from instituting compliance programmes that it does not comply with, little seem to have been learnt. In 2006, Kobe Steel admitted falsifying soot-emissions data from the blast furnaces at two of its factores. It also took part in bid-rigging for a bridge project in 2005, and failed to report income to tax authorities in 2008, 2011, and 2013. The company exceeded established limits for ground and water pollution in 2006. And illegal political funding to candidates in local assembly elections in 2009 forced the then CEO and chairman to resign.

Kobe Steel's Internal Reporting Systems

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An internal report concluded that the company had elevated the pursuit of short-term profit over the maintenance of scrupulous quality standards because of lax oversight by senior executives and a silo culture that discouraged whistleblowing. Kobe Steel’s CEO, Hiroya Kawasaki, said that the record falsification practices were at least a decade old but that, because older records were incomplete, it might have been going on longer.

The report also outlined reforms, including automating record keeping for product tests and requiring multiple employees to verify that test results are accurate. In addition, last month Kobe Steel said it would spend about 10 ¥10 billion ($88 million) on equipment and Internet of Things solutions that will automatically record inspection data and eliminate opportunities for human tampering. The report also blamed plant managers for the problem, while recognising that executives set unreasonable production targets and then failed to ask how subordinates met them.

“When you’re in manufacturing and you’re not compliant with safety standards, if an employee gets hurt, for example, that means a loss of business and therefore value,” said Abel. “If you go back to the Massey mining incidents, where people lost their lives, that caused a huge fall out since investors thought they were complying with health and safety procedures, but as it turned out that was not the case and the mine shut down with a huge loss of business. It’s a similar issue with Kobe Steel, where you have a very competitive market, you have customers who are putting their products into things that are flying at 30,000 feet, or going at two hundred miles an hour; it’s in that context that it’s a safety issue. If they are selling products that are not meeting certain standards, then the fallout from that is the possibility of defective products, people injured, loss of customers and all types of risk and credibility issues.”

I asked Abel to explain what other consequences the compliance failures might have. “If you say you are complying with certain standards, it means you receive certain accreditations which means you can sell products to government contractors, for example. That’s what investors want to see that makes something a credible investment. But when it comes out that they are just essentially windowdressing, then investors become very unhappy and punish the company. In the worst case, you have defective products which can wreak all kinds of havoc. “If you look at it from a market perspective,” he added, “to be a credible stock that people want to invest in, especially if you’re overseas, you’re relying on these compliance statements because you can’t see at firsthand what’s actually happening. I think that Kobe was doing everything they could to look like a credible stock. And they were relying on that sense of Japanese quality that goes back to the 80s, especially in car manufacturing.”

Abel noted that the stock had dropped by 40 percent between October 9th and 13th, but that it had since bounced back a bit. “In my opinion,” he said, “[the bounce back is based on] the fact that their customers have gone through their due diligence in looking at what they received from Kobe and found that, to date, there haven’t been any safety or defect issues that would cause them to demand some kind of recall. Since most clients have done that, that particular liability is becoming less and less. Investors were saying that if all 500 customers were saying they want their money back or for Kobe to pay compensation, that would be extremely expensive … but now it may be only a small number of customers who will demand compensation. But the stock is still depressed and will remain so because, looking forward, they have damaged their reputation, and that is going to result in lost customers or the inability to get contracts. We also don’t know the full extent of the liability. If the DoJ issues charges, that also puts pressure on the stock.”

Abel noted that both internal and external pressures would seem to have forced Kobe into this behaviour: “Kobe is the number-three steel manufacturer in Japan, and they’re always striving to be number one, so you have a highly competitive market where if you start competing on price, especially when you have Chinese steel in the picture, that’s often a losing game and things like this can happen.”

Governance remedies are an expected outcome of successful class-action lawsuits. Abel said: “It will be interesting to see what kinds of remedies are handed down following the outcome of a government investigation. There have been a few cases of securities class action in Japan, for example the Olympus scandal settled with shareholders in 2015. From what we have seen with that case, and with Toshiba and Takata, the Japanese government are very reluctant to bring criminal charges, or it would take a very long time. On the other hand, the DoJ could bring criminal charges that would bring whole other level of scrutiny. At this stage, it doesn’t sound like the Japanese authorities are going to do anything other than investigate.” While the current suit will be filed in the U.S., the MALG is considering also filing in Japan: “We are looking at filing a case in Japan, which is different from how we would do it here, but that would probably be a better venue to push for governance changes. In terms of governance remedies I would start with the board and trying to determine whether the independent directors were actually independent. As far as compliance initiatives, it’s not like they don’t have them already, they are just not implementing them.”

Abel said there had been significant interest from U.S. investors in joining the class action, but that a filing date had not been set, though it could be as early as this week. “We’re focusing on U.S. investors,” he said, “just because this is the way the securities laws work over here; we have to make sure that they purchased stock in the United States. We have had calls from Japanese investors and others who have purchased the stock on the Tokyo exchange, there is some international interest.”

The Japanese Government Pension Investment Fund (GPIF) owns shares in Kobe Steel. I asked if it would be part of a lawsuit. “When you file in Japan it’s not a class action like it is in the U.S., it’s more of a collective action, where you essentially create a shareholder foundation, you tell shareholders what you’re doing and they have to opt in. Whereas in the U.S., shareholders are automatically part of the class and they have to opt out. I don’t know whether it’s likely, but individual investors in Japan can seek individual remedies. I’m not a Japanese attorney, but, for example, the GPIF could consider pursuing this directly or as part of a foundation that might include foreign investors. It would have to determine what is in its best interests and where it has the greater influence. It could be more that the fund determines it has a greater chance of resolution by engaging directly with Kobe.”

Nicholas Benes, head of the Board Director Training Institute of Japan, said that the GPIF had sued Toshiba for $10 million under very similar circumstances. “It is only one asset manager that is suing, almost certainly under Article 21-2 Japan securities law (FIL) which makes it very easy for plaintiffs to sue and claim a ‘presumed damages amount,’ and then shifts the burden of proof to the defendant company (unlike U.S. law) to disprove its negligence.” GPIF has almost 34 million shares of Kobe stock that was worth, before the scandal, around ¥35 billion and is now worth considerably less, so the prospect of at least “one manager” suing seems high.

The scandal’s effects look set to affect the entire Kobe region. Kenji Semoto, a researcher at Zero Degree Design, referred to an article in Kobe’s regional newspaper, which showed “(ex-)Kobe executives virtually on the board of every economic-business association in the Kobe region and tightly connected to even bigger zaibatsu [a large Japanese business conglomerate] in Osaka. While these things may not be necessarily and automatically a bad thing, it can be imagined how difficult it would be to come out clean of past historical errors.”

And Kobe’s problems may spread even wider. “It is interesting that you have the Japanese Prime Minister, I’m not suggesting anything, but it is interesting that we haven’t seen any news on how he feels about the scandal; is it embarrassing for him?” asked Abel. “His campaign to become Prime Minister included his working at Kobe Steel, it’s part of his story; we don’t know what the impact is going to be, but it is interesting.” When Shinzo Abe speaks about Kobe, his message is that it is “important for you to learn from your mistakes.” Something that Kobe clearly had no intention of doing.

“Yes, he made a batch of pipes,” said Abel, “that was completely wrong and he thought he was going to be fired, the story didn’t really go into much detail, but he survived. It would be interesting to find out what happened, did they replace the defective pipes or did they just sell them anyway?”